Study guide
This chapter continues within NASAA outline Section III, focusing specifically on retirement plans and special-purpose accounts -- material that is tested with precise numeric and rule-based questions about contribution limits, distribution rules, and account ownership/control features. It covers traditional and Roth IRAs, employer-sponsored plans, required minimum distributions, and education and custodial accounts such as 529 plans, Coverdell ESAs, and UTMA/UGMA custodial accounts.
Traditional and Roth IRAs
A traditional IRA allows contributions that may be tax-deductible depending on the owner's income and participation in an employer plan, grows tax-deferred, and is taxed as ordinary income upon withdrawal; traditional IRA owners must begin taking required minimum distributions (RMDs) once they reach the applicable RMD age, and withdrawals before age 59 1/2 are generally subject to a 10% additional tax absent an exception. A Roth IRA is funded with after-tax contributions (subject to income eligibility limits), grows tax-free, and qualified withdrawals (after a five-year holding period and a qualifying event such as reaching age 59 1/2) are entirely tax-free; critically, Roth IRAs impose no required minimum distributions during the original owner's lifetime, which makes them a valuable estate-planning tool even though inherited Roth IRAs are subject to distribution requirements for the beneficiary. Both account types share the same annual contribution limit (combined across traditional and Roth contributions), and being retired or no longer working does not exempt a traditional IRA owner from RMD obligations, nor does it change the fact that RMD rules apply to individual retirement accounts just as they do to employer-sponsored plans. A common exam trap is assuming RMD rules apply only to employer plans, or that reaching RMD age forces distributions from a Roth IRA as well as a traditional one.
Employer-Sponsored Retirement Plans
Qualified employer plans (meeting IRC requirements for favorable tax treatment) include defined benefit plans, which promise a specified retirement benefit typically based on salary and years of service with the employer bearing investment risk, and defined contribution plans, such as 401(k) plans, where the benefit depends on contributions and investment performance with the employee typically bearing investment risk and often directing investment choices. SEP IRAs (Simplified Employee Pension) and SIMPLE IRAs are simplified employer-sponsored retirement vehicles designed for small businesses and self-employed individuals, funded primarily or entirely by employer contributions in the case of SEPs, with generally lower administrative burden than a full 401(k). Nonqualified plans, including deferred compensation arrangements, do not receive the same tax-favored treatment, are typically offered selectively to executives, and generally lack the creditor protections and nondiscrimination requirements that apply to qualified plans. ERISA (the Employee Retirement Income Security Act) establishes fiduciary standards, funding, vesting, and disclosure requirements for private-sector employer retirement plans, and advisers who provide investment advice regarding such plans may themselves be considered fiduciaries under ERISA, layering an additional duty of care on top of the Investment Advisers Act's own fiduciary standard.
Required Minimum Distributions and Rollovers
Required minimum distributions force tax-deferred retirement accounts to begin paying out over the owner's remaining life expectancy once the applicable age is reached, ensuring the government eventually collects tax on dollars that were never taxed going in; the RMD amount is calculated by dividing the prior year-end account balance by a life-expectancy factor from the applicable IRS table. Failure to take a full RMD by the deadline can trigger an excise tax on the shortfall. Rollovers allow an account owner to move funds between qualified plans and IRAs (or between IRAs) without immediate taxation, provided the rules are followed: a 60-day rollover must be completed within 60 days of receipt of the funds to avoid taxation and potential penalty, and an individual is generally limited to one 60-day IRA-to-IRA rollover per 12-month period, while direct (trustee-to-trustee) transfers are not subject to this limitation and are the generally recommended method to avoid inadvertent taxable events. Converting a traditional IRA to a Roth IRA (a Roth conversion) triggers current ordinary income tax on the converted pre-tax amount but allows future qualified withdrawals to be tax-free, a strategy often considered when a client expects to be in a higher tax bracket in retirement or wants to eliminate future RMDs.
Education Savings Vehicles
A 529 college savings plan allows the account owner (often a parent or grandparent) to retain full ownership and control of the assets indefinitely: the owner can change the designated beneficiary to another qualifying family member without tax consequence, and can even reclaim the funds through a nonqualified withdrawal (subject to ordinary income tax and a penalty on the earnings portion only), meaning the beneficiary never automatically gains control of the account. Contributions grow tax-deferred and qualified withdrawals for education expenses are entirely tax-free at the federal level. A Coverdell Education Savings Account (ESA) is a smaller, more restricted vehicle subject to contribution limits and income eligibility caps; contributions are irrevocable gifts to the named beneficiary, unused balances generally must be distributed to the beneficiary or rolled over to another family member by the time the beneficiary reaches age 30, and the donor does not retain the broad ownership and redirection rights available under a 529 plan. Both vehicles differ sharply from custodial accounts in who retains control, a distinction the exam tests directly by describing a donor's specific goals (retaining control, redirecting funds, preventing the child from taking control at majority) and asking which vehicle satisfies all of them.
UTMA/UGMA Custodial Accounts
Uniform Transfers to Minors Act (UTMA) and Uniform Gifts to Minors Act (UGMA) accounts allow an adult custodian to hold and manage assets for a minor's benefit, but any contribution is an irrevocable completed gift belonging to the minor from the moment it is made -- the custodian manages the account only until the minor reaches the age of majority or the state-specified UTMA transfer age, at which point the minor gains full, unrestricted control of the assets regardless of the custodian's or donor's wishes. Because the gift is irrevocable and complete, contributed assets cannot be redirected to a different beneficiary, reclaimed by the donor, or withheld from the minor once they reach the transfer age, which sharply distinguishes UTMA/UGMA accounts from 529 plans. Custodial account assets are counted as the minor's own assets for financial aid purposes (generally assessed more heavily than parental assets) and any income is taxed to the minor, subject to 'kiddie tax' rules that tax a portion of a minor's unearned income at the parent's marginal rate above an annually adjusted threshold. A custodian must manage the account prudently and solely for the minor's benefit, cannot use the funds for their own purposes or ordinary parental support obligations, and must transfer full control at the statutory age even if the custodian believes the minor is not ready to manage the funds responsibly.
Key terms
- Required minimum distribution (RMD)
- — The minimum amount a traditional IRA or qualified plan owner must withdraw annually beginning at the applicable RMD age; Roth IRAs have no lifetime RMD for the original owner.
- Roth IRA
- — An IRA funded with after-tax contributions that grows tax-free, with qualified withdrawals entirely tax-free and no lifetime RMDs for the owner.
- Defined benefit plan
- — An employer retirement plan promising a specified benefit based on salary and service, with the employer bearing investment risk.
- Defined contribution plan
- — An employer retirement plan (e.g., 401(k)) where the eventual benefit depends on contributions and investment performance, with the employee typically bearing investment risk.
- 60-day rollover
- — A distribution from a retirement account that avoids current taxation if redeposited into an eligible retirement account within 60 days; limited to one per 12-month period for IRA-to-IRA rollovers.
- 529 plan
- — A tax-advantaged education savings account in which the owner retains control, may change beneficiaries among family members, and can reclaim funds (with tax and penalty on earnings).
- Coverdell ESA
- — A restricted education savings account funded with irrevocable gifts to a named beneficiary, subject to contribution and income limits, generally distributed by age 30.
- UTMA/UGMA account
- — A custodial account holding an irrevocable gift for a minor, which the minor gains full control of at the age of majority or state transfer age.
- Roth conversion
- — Moving assets from a traditional IRA to a Roth IRA, triggering current ordinary income tax on the converted amount in exchange for future tax-free qualified withdrawals.
- Kiddie tax
- — Rules taxing a portion of a minor's unearned income above a threshold at the parent's marginal tax rate, relevant to UTMA/UGMA custodial account income.
Exam tips
- If a client scenario emphasizes retaining control, redirecting to another family member, or reclaiming funds, the answer is almost always a 529 plan, not UTMA/UGMA or Coverdell.
- Roth IRA = no lifetime RMD for the owner. Traditional IRA = RMDs required regardless of retirement status. Don't let 'she's retired' distract you into thinking RMDs are avoidable.
- UTMA/UGMA contributions are irrevocable gifts to the minor -- the custodian can never redirect the funds to a different child or take them back, unlike a 529 owner.
- Distinguish direct trustee-to-trustee transfers (unlimited) from 60-day rollovers (limited to one per 12 months for IRA-to-IRA) -- a repeated-rollover question is testing this limit.
- Defined benefit = employer bears investment risk, promised payout. Defined contribution = employee usually bears investment risk, payout depends on performance. Map risk-bearing party first.
- For education-account questions, check three things: who owns/controls it, what happens to leftover funds, and whether the beneficiary can be changed -- these three facts alone distinguish 529, Coverdell, and UTMA.